G'day monkeys!
I've got a question that might totally undermine its placement in the bullpen (ibankers might just rip me apart), but it's something that I've wondered about and have asked some people about this. For anyone who's wondering, I'm an undergrad so please go easy, I'm trying to learn.
Anyway, it is plain knowledge that bond prices act in inverse to interest rates (bond prices go up when interest rates go down, etc). And this makes perfect sense when you explain it as a case of relatively higher yields, driving up bond prices.
However, someone once explained to me that it does not always hold true. For example, with callable bonds in a situation of declining interest rates, the bond issuers may issue a new bond at prevailing rates and thereby refinance their debt more cheaply. As a result of this, the pre-existing bond goes down in value as the yield to maturity declines because of the callability.
I did inquire further about whether that implies that ONLY callable bonds prices act in tandem with interest rates, but he explained that almost all bonds issued today are callable, which confuses me enough to ask why every b-school worldwide are teaching the inverse relationship between bond prices and interest rates?
Any insight, advice will be appreciated! Thank you for your time.
bump!
In a bond issue the callable bonds will be priced yield to worst. Which usually means they will be priced to the call date. Think of it as if interest rates are falling the investor KNOWS his bond will be called in 10 years (or whatever the call is). So why would you pay full price for a 15 year bond when you will not realize your yield in the last 5 years?
double.
Firstly, I was always under the impression the yield rate was a function of the bond prices - not the other way around (when it's issued not later on) So when the demand for a bond goes up it's YTM goes down and vice-versa. That's because as the bond prices rise, the coupon payment remains the same so the yield goes lower.
For the callable bond, that's correct. The issuer can 'call' the bond and refinance the debt with cheaper loan - which is what many do. I read somewhere that around 300 bn $ of bonds are maturing in 2013, so they will be refinanced at the current low interest rate around the world.
"As a result of this, the pre-existing bond goes down in value as the yield to maturity declines because of the callability." -- Not sure what you mean here, but if the YTM declines that means there is demand for the bond. People are willing to buy the bond despite the high price, and hence low yield. Of course people will only buy the bond at a high price, if its yield is higher and safer than the treasury rate etc. I think callability means the bond coupon rate is in fact slightly higher than convertibles or plain vanilla.
I am not sure if all bonds are callable, but I guess in periods of distress in the company, people will rather take some losses than a total loss.
All bonds are not callable. The main reasons a bond would not be callable are because it is a shorter maturity and there is no reason to add the call option (say 12 years or something, no reason for a 10 year call if you can only refund those last 2 years, will not be worth paying for the optionality). Also, a lot of refundings do not have a call because again, once you wait 10 years and call the bonds there will only be a few years left on the maturity and no reason to be able to call it. I'm not sure about corporates but I would say 80-90% of muni new money issues have a call and closer to 50% of refundings do.
The easier answer: Callable bonds can't have negative duration. At best, their sensitivity to interest rates would be 0, when yields are at a level that prices the bonds well above their call price. The price of the bond in this case is usually the call price, plus the "extra yield" you'll receive prior to the call date (ie there might be a coupon payment prior to the call). The bonds have negative convexity beyond a certain level though as their likelihood of getting called increases, but duration is always positive.
The easier answer: Callable bonds can't have negative duration. At best, their sensitivity to interest rates would be 0, when yields are at a level that prices the bonds well above their call price. The price of the bond in this case is usually the call price, plus the "extra yield" you'll receive prior to the call date (ie there might be a coupon payment prior to the call). The bonds have negative convexity beyond a certain level though as their likelihood of getting called increases, but duration is always positive.
... and convexity is "usually" positive, ie not negative for all values of r
Thanks guys for all the replies,
JTB, what I meant was that:
for example, a bond with a tenor of 15 years and a call date in 10 years, is called. Thus the bondholder loses 5 years of potential coupon payments, and thus the YTM decreases. Thus with lower yields, bond prices will have to fall to stimulate demand for the bonds. Is this correct?
To all,
Yes I believe as well that not all bonds are callable. One person I consulted, however, told me that many (if not most) of issued bonds carry a callability feature because the issuer wishes to give himself/herself/itself the option to redeem early and thus reduce the exposure to additional coupon payments.
teenagepirate, can you explain your reply in simpler terms? Haha I'm sorry I don't quite understand.
Thanks for the help guys!
Assume no coupons to be paid before call date, bond coupon at 5% (implies bond trades at par at 5% yield level), callable at par and for simplicity assume the call date is one year from now. The bond's value is going to be 100/(1+y) for all values of y below 5% ie. a negative relation between interest rates and yield but not as steep as the negative relation for levels of y above 5%. At levels of y above 5%, the bond will not get called and the price is going to be C/(1+y) + C(1+y)^2 ... + (100+C)/(1+y)^t, which will have a greater sensitivity to y.
As the call date gets nearer, for yield levels below 5%, the sensitivity of yield to price decreases (the exponent becomes smaller and smaller). But never negative, only approaching 0.
I think explaining convexity is a bit pointless if you don't understand a duration based explanation, but don't worry it's not so important for this basic principle here.
Just think of the call in terms of prices. If the bond can be called at 100 in two years, the price can't go that much higher than 100 no matter how low interest rates go. If rates go lower, it will be called at 100. So, you price the bond to the call instead of to maturity. Look up yield to worst.
Interest rates and Bonds (Originally Posted: 09/19/2009)
I just read in the WSJ this statement:
"When interest rates go up, investors in longer-term bonds can get slaughtered"
Can anyone explain this to me?
you do understand the relationship between bonds and interest rates right?
Interest rates and bond prices are inversely related. But what is simplest way to explain why this relationship exists?
If interest rates go up, the value of the bond decreases and the principal you paid initially will have decreased. While the yield would have went up, you only receive annual payments of the yield when you bought the bond initially. Is this correct?
Yes I understand the relationship between bonds and interest rates. What I don't understand is how longer term bonds can get slaughtered?
If interest rates go up, bond price goes down. I guess this is a bad thing for long term bond holders because their bond is worth less than par value. But what if they don't ever sell it and wait for it to expire hence receiving the par value amount and coupon payments. How is this a bad thing?
I think the problem is that if interest rates go up, you lose in the sense that you can be earning more (through coupon payments) from bonds that are offering higher interest rates. Is this right?
The reason why longer term bonds get slaughtered is because they have a longer duration, which mathematically (and intuitively) means that their value are more sensitive to changes in the interest rate. It is part a functional understanding.
Chasing Consultants, Breaking Bankers http://chasingconsultantsbreakingbankers.blogspot.com/
What will happen to the yield of HY bonds if interest rates go up? (Originally Posted: 04/03/2013)
Can this scenario happen?:
If rates go up, refinancing slows down and the primary market shrinks.
In addition, since rates has gone up, the old HY bonds' coupons are not attractive anymore. So the demand for these bonds will decrease, which means that their value will decrease (and that will cause the yield on them to increase)...
Is this what would happen if the Fed said they were done with QE or with fixing interest rates...
Thanks
Interest rates going up means the price going down.
Interest rates up means HY Bond Yield will go up and price will go down depending on the duration of each bond.
Lets say that interest rates for a 10 yr t bill is 2% and the current spread between 10 yr t-bills and X co. HY bond is 300bps (3%). This means that the current yield on the X co 10 yr bond is 5%. Lets say tomorrow Bernake raises rates by 1% and the spread stays the same. This means that any new X co. 10 yr issue will have to be issued at a 6% yield. All existing X co. 10 yr bonds will have to adjust to yield 6% or else they would be arbitrage. Therefore, the price of existing X co. 10 yr bonds will have to go down.
Now this is case is very simple, the real world is a lot more complex as the spread does change everyday and there are other factors that affect yield/price.
Good explanation.
Incidentally, there are plenty of HY bond traders expecting this to happen, and soon. Volume to the put side of the HY Bond ETFs has gone through the roof lately.
Out of curiosity, where are you getting your data? I'd like to take a similar look at HY munis.
Ok, now multiple people throwing the poo. I guess some people don't like that if the interest rates go up the bonds will go down in value. Not real complicated people.
1) Primary Market shrinking is supportive of bond prices as supply HY is closer to equities than IG, so any rates increase would hit IG bonds far more than HY bonds. The reason for this is simple: If you have a 800bp credit spread, it matters less if rates go up by 25bps than if your credit spread is only 50bps.
I am always so confused every time someone says "rates go higher."
LOL. The other day I was having lunch with an old school auditor (like Peat Marwick old school) and he says, "Do you realize we have a generation of bankers now for whom a DCF valuation is theoretical because they've never actually seen interest?"
Brilliant hahaha.
It's important to note ABCs correction about the influence of the primary market because you got that one backwards.
Seriously, if you tell me rates go higher, to me it means rates are bid and yields, ie what people think of as "interest rates," are lower. Rates = bonds.
In reality, if the Fed raises rates and Treasury yields rise 0.5-1%, it will have a pretty minimal impact on HY. Guys are still starved for yield and 5% on a 5-year will continue to look pretty good for most names. Keep in mind HY is lower duration, which is the mathematical equivalent of "who cares if underlying rates are 1% or 2% if I'm making 6%." IG will get hammered, though.
But yes, mathematically it should be like an airplane - yield up, price down.
I think supply plays a big role. I also think as the economy improves we will see the underlying credit quality in HY improve which would also support current prices. The improvement in a company's underlying credit rating will allow company's to continue to borrow if at more favorable rates which would continue to help support current pricing levels. Besides, the yield pick up on HY vs IG bonds isn't worth it.
I think a bigger question is - whats going to happen when the Fed stops purchasing close to 75% of the credit market and all of the sudden there is not a change in demand and a massive increase in supply. Anyway you look at it, the bond market is going to blow up within the next three years.
Thanks for the heads up! I also heard the national debt is really big, is that true?
Nahh we've got a balanced budget and obama isn't a retarded piece of shit.
Still hasnt happened.
my simple answer to your question: -if the Feds stop the QE and ZIRP measures, it means they have a conviction that the US economy has already recovered to the healthy level -which means people are turning away from HY bonds into equities or riskier assets. -that would increase the yields of HY bonds, driving down their prices -at the same time, the yield of 10-year TN will also go up, probably to 2.5%
however: it is very unlikely they will STOP the measures in the near future since the unemployment rate is still far above 6.5%
a more likely scenario: -the Feds will CONTINUE its ZIRP but will gradually REDUCE the monthly purchases of bonds, probably from USD 85 mln to 50 mln and eventually to 0 -that's because the inflation rate has already risen to 2% last month, which is close to the 2.5% upper limit set by the Feds -and also because the US economy is showing signs of recovery such as 1) factory orders rising to 3%, 2) home sales above 400k level for two consecutive months and 3) gradually declining unemployment rate
just my 2 cents
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